Energy Costs Remain Key Drag on U.S. Growth

The soaring real cost of energy has been one of the most critical economic trends over the past decade. Global oil consumption has advanced by an annual average of 1.1m bpd since 2000, while non-OPEC output has risen annually by less than 0.6m bpd. Since 2000, non-OECD demand has risen from just over a third to almost half of global demand.

The latest cyclical recovery in oil demand is focusing concern on the availability of spare capacity; only OPEC has any. Conventional wisdom has it that spare production capacity amounting to about 5% of global supply provides an effective buffer against surprise developments in the market. It fell as low as 2% during the 2008 oil spike. Non-OPEC producers, accounting for 57% of total global supply, simply have no spare capacity. Even if Chinese GDP growth slows to a trend 7-8%, non-OECD demand should continue to exert a steady squeeze on spare capacity until significant new sources such as shale oil come on stream and EM subsidies are slashed to constrain demand.

Click to enlargeSource: IEA

Energy intensity (the amount of energy used for one unit of GDP) grew last year at the fastest rate since 1970. Global oil consumption grew by 2.7M BPD or 3.1%, the strongest growth since 2004 and twice the 10-year average. Overall energy consumption growth last year was 5.6%, the highest rate since 1973. Oil prices averaged the second highest level on record, and consumption reached a new record level of 87.4m bpd. Available net exports from the Middle East are under pressure as subsidized local consumption grows 5% annually. Oil discovery costs are up from $4 in 1999 to $23-$25 since 2008. Marginal production cost per barrel reached $87 in 2008 and has ranged from $70-80 since. Non-OPEC output ex Russia has stagnated since 2000.

China has doubled its coal consumption over the past decade to over 1,700 MTOE last year. Over the same period, the price of coal has risen five-fold. China is now the world’s largest consumer of energy at over 20% of global consumption but only uses 10% of the per capita energy consumption of the U.S. Within 20 years, demand growth requires adding the production equivalent of at last another 4 Saudis. The real breakthrough in marginal fossil fuel supply has been in U.S. shale gas, and potentially shale derived oil. U.S. oil production from shale has grown to more than 500k bpd since exploration began in 2009 and could reach 3m bpd by 2020, boosting the country’s status as the third largest producer after Saudi Arabia and Russia.

Click to enlargeSource: BP

In textbook economics, prices rise and fall in order to balance supply and demand. In the oil market, however, supply and demand are extremely slow to respond to price shifts, i.e. supply is price inelastic in the short-term, which means that prices can undergo big swings before a balance is restored.

It takes years to develop new resources, and it is difficult to turn production on or on short notice. When new supplies threaten to flood the market or a sudden drop in demand (for example, due to recession) leaves sellers without ready buyers, prices can plunge before producers start shutting the taps. Oil prices naturally tend toward extremes, and since the mid-1980s spare production capacity has been the only tool available to dampen this volatility. If demand jumped unexpectedly or if supplies were suddenly disrupted, OPEC producers with spare capacity, especially Saudi Arabia, would release more oil, obviating the need for prices to swing in order to balance supply and demand. Now, much of OPEC’s influence is gone. Saudi Arabia and its partners no longer consistently hold the large volumes of spare capacity they once did, implying that the oil market is in for a volatile ride, at least through mid decade, with major economic and geopolitical consequences, not least a higher risk of relatively frequent recessions.

Every $10 rise in crude typically trims U.S. GDP growth by 25bps, so $40 takes roughly a full point off growth (and vice versa). A price around $125/bl rations demand in OECD countries, but only prices in excess of $140 are likely to create demand destruction in emerging economies, unless subsidy reform accelerates. Libya’s crisis has taken 1.5m bpd out of global supply. The Saudis have signaled their willingness to boost output from 9m bpd to more than 10m this summer. If they can deliver and we see a political endgame in Libya as EM demand growth slows, a multi month correction is likely in H2 toward $100/bl in Brent. But OPEC's spare capacity will continue to decline and threaten a medium-term test of new nominal highs until demand is curtailed.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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